Managerial Economics Lecture Notes

A. Nature and scope of managerial economics

1. What is economics, management and managerial economics?
Economics is the study of human being in producing, distributing and consuming
material goods and services in a world of scarce resources.
Management is the science of organizing and allocating of firms scarce resources to
achieve its desired objectives.
Managerial economics use analysis to make business decisions involving the best use or
allocation of an organization’s scarce resources.
Managerial economics helps managers recognize how economic forces affect
organizations and describe economic consequences of managerial behavior. It also links
economic concepts and quantitative methods to develop vital tools for management
decision making.
2. What is a firm?
 Firm is useful for producing and distributing goods and services.
 The firm can be viewed as a series of contractual relationships that connect
suppliers, investors, workers, and management in a joint effort to serve the
customers.
 The firm also relates to various functional departments such as marketing
department, production department, finance department, human resource
department and etc.
3. What is the Theory of the Firm?
The Theory of the Firm is the basic business model.
4. What is expected value maximization?
The firm primary goal is to have profit maximization on the short-run however,
this has broadened to consider the time value of money.
Expected value maximization is the optimization of profits in the light of uncertainty
and the time value of money.
5. What are the limitations of the Theory of the Firm?
 Managers may choose to optimize or satisfice.
 Optimize means seek the best solutions.
 Satisfice means seek satisfactory rather than optimal results.
  Managers are encourage through generous compensation package and stock options
to discourage own personal utility or welfare maximization.
 The need for corporate social responsibility aside from profit and value
maximization.
6. Explain constraints (self-imposed and social constraints) and the Theory of the Firm
Theory of the Firm
Profit maximization
Expected value maximization

Constraints
Self-imposed
Limited availability of inputs-skilled labor, raw materials, machinery, funds/capital
Social constraints
Legal restrictions

7. Differentiate business profit versus economic profit

Business profit is the residual of sales revenue minus the explicit accounting costs of
doing business.
Economic profit is the business profit minus the implicit costs of capital and any other
owner-provided inputs such as owner provided inputs(opportunity cost)
8. What is variability of business profits?
Business profits can be measured using the company’s financial statements. Limitation
on the use of financial statements includes differences in accounting policies and
procedures, inflation, and window dressing.
Difference in profits measured using financial ratios such as Profit Margin and Return on
equity (ROE).
Profit margin is calculated by dividing accounting net income by sales. The higher the
rate the more favorable.
Return on equity is calculated by dividing accounting net income by the book value of
the total assets minus total liabilities (equity).The higher the rate the more favorable.
Benchmarking should be made to compare business profits within the same industry.
Business profits vary depending on the nature of business.
9. Define and explain the following profit theory why profit varies among firms:
5.1 Frictional Profit theory
A profit theory wherein an abnormal profit is observed following
unanticipated changes in demand or cost conditions. Unanticipated
shocked produce positive or negative economic profits for some firms. For
example, at the time of sharp size in petroleum prices in the 1990 as a
result of US-Iraq war many petroleum-refining firms enjoyed handsome
economic profits. Similarly, as a result of slowdown in world trade in the
years 1999-2001 many Indian firms doing export business suffered losses
due to the decrease in the demand for their products in the USA and other
countries.
5.2 Monopoly Profit Theory
A profit theory wherein an above normal profit caused by barriers to entry
that limit competition such as high capital requirements. Monopolies exists,
especially in the production and supply of water, electricity, energy, etc.
Monopoly profits are subject to heavy taxes or otherwise regulated.
5.3 Innovation Profit Theory
A profit theory wherein an above normal profit results from successful
invention or modernization. Bill Gates introduced Windows operating system and
MS-office types of computer software and has become billionaire by making huge
profit on his innovations. Another example also is Apple Corporation that earned
above normal rates of return as an early innovator with its iPod line of portable
digital music and video players. Another example also is Facebook.
5.4 Compensatory Profit Theory
A profit theory wherein an above normal rates of return results from
efficiency. This includes extraordinary success in meeting customer needs and
maintaining efficient operation. On the other hand inefficient firms earn below
normal rate of return. For example, the Ford supply chain management which
integrate suppliers into their system and making delivery more efficient, lower
inventory levels, shorter cycle time, better processes and improve service level on
the customer end. Another example is Toyota’s Total Quality Management
(TQM) which is a quality system based on lean management. It is a proven
effective management philosophy which focuses on attaining the best in every
aspect of the business. The company established The Toyota Way, a set of
business principles, in 2001. It is based on kaizen — continuous improvement —
and strives to eliminate waste and overproduction, as well as to create a
bureaucratic system where any employee can suggest a change where they see fit.
 10. What is the role of profits in the economy?
Profits serve as a sign in making managerial decisions:
o Above normal profit signals that the firm or industry output should be
increased, expansion of current firms or entry by new competitors.
o Just above normal profits signals the need for expansion and entry.
o Below normal profit signal the end for contraction and exit.

B. Economic Optimization
1. What is optimal decision?
 Optimal decision is the choice alternative that produces a result most
consistent with the managerial objectives.
 Available choices should be analyzed by appropriate cost and benefit.

2. Define spreadsheet, equation, total revenue, dependent variable and independent

variable

Spreadsheet is a table of electronically stored data. Accounting income statement and

balance sheet format displayed electronically, these tables are referred to as spreadsheet.
Equation is an analytical expression of functional relationships or connections among
economic variables.
Total revenue is a function of output. TR=f(Q)(TR=Total Revenue, Q=output)
Dependent variable means that y variable determined by x values.
Independent variable means that x variable determined separately from the y variable.
TR is the dependent variable while Q is the independent variable.
3. What is marginal revenue?
Marginal revenue is the change in total revenue associated with a 1 unit change in
output.
4. Explain revenue maximization?
Revenue maximization occurs at the activity level that generates the highest revenue.
5. Differentiate short-run cost function from long-run cost function?
Short-run cost functions are cost relations when fixed cost are present, used for day to
day operating decisions.
Long-run cost functions are cost relation when all cost are variable, used for long term
planning.
6. Define total cost, fixed cost and variable cost
Total cost comprise of fixed and variable expenses.
Fixed cost are expenses that do not vary with output.
Variable cost are expenses that fluctuate with output.
7. Differentiate marginal cost from average cost
Marginal cost is the change in total cost associated with 1-unit change in output.
Average cost is the total cost divided by the number of units produced.
8. What is the average cost minimization?
Average cost minimization is the activity level that generates the lowest average cost.
9. Differentiate total profit from marginal profit
Total profit is the difference between total revenue and total cost.
Marginal profit is the change in total profit due to a 1-unit change in output.
10. What breakeven point?
Breakeven point is output level with zero profit. Total revenue is equal to Total cost.
ILLUSTRATIONS
Table 1 REVENUE RELATIONS
A B C D E F
Total Change in
Quantity Revenue(TR) Marginal Change marginal
Sold(Q) Price(P) (A*B) Revenue(MR) in Price revenue
0 Php24.00 Php0.00 Php0.00 Php0.00 Php0.00
1 Php22.50 Php22.50 Php22.50 Php1.50 Php0.00
2 Php21.00 Php42.00 Php19.50 Php1.50 Php3.00
3 Php19.50 Php58.50 Php16.50 Php1.50 Php3.00
4 Php18.00 Php72.00 Php13.50 Php1.50 Php3.00
5 Php16.50 Php82.50 Php10.50 Php1.50 Php3.00
6 Php15.00 Php90.00 Php7.50 Php1.50 Php3.00
7 Php13.50 Php94.50 Php4.50 Php1.50 Php3.00
8 Php12.00 Php96.00 Php1.50 Php1.50 Php3.00
9 Php10.50 Php94.50 -Php1.50 Php1.50 Php3.00
10 Php9.00 Php90.00 -Php4.50 Php1.50 Php3.00

TR= f(Q)
TR= P x Q
1. What is the demand curve? P=24-1.5(Q), where 24 is the intercept and 1.5 is the slope
coefficient

2. Recompute Total Revenue(TR) using the linear demand curve for 5 quantity sold
TR= Php24-Php1.5(5) x 5
TR= (Php24-Php7.5) x 5
TR= Php82.50

3. What is the marginal revenue over the range from 5-6? Php7.50

4. At what quantity is the revenue maximization? 8 units

MR=0
Php24-Php3Q=0
Php3Q=Php24
Q=8
 Table 2 COST RELATIONS
A B C D E F G

Variable
Quantity Total Marginal Average cost per
Sold(Q) Fixed Cost Variable Cost Cost(B+C) Cost Cost(D/A) unit(C/A)
0 Php8.00 Php0.00 Php8.00 Php0.00 Php0.00 Php0.00
1 Php8.00 Php4.50 Php12.50 Php4.50 Php12.50 Php4.50
2 Php8.00 Php10.00 Php18.00 Php5.50 Php9.00 Php5.00
3 Php8.00 Php16.50 Php24.50 Php6.50 Php8.17 Php5.50
4 Php8.00 Php24.00 Php32.00 Php7.50 Php8.00 Php6.00
5 Php8.00 Php32.50 Php40.50 Php8.50 Php8.10 Php6.50
6 Php8.00 Php42.00 Php50.00 Php9.50 Php8.33 Php7.00
7 Php8.00 Php52.50 Php60.50 Php10.50 Php8.64 Php7.50
8 Php8.00 Php64.00 Php72.00 Php11.50 Php9.00 Php8.00
9 Php8.00 Php76.50 Php84.50 Php12.50 Php9.39 Php8.50
10 Php8.00 Php90.00 Php98.00 Php13.50 Php9.80 Php9.00

TC=FC+VC
1. At what quantity is the cost minimization?
4 units
 Table 3 Quantity, Revenue, Cost and Profit Relations
Quantity Total Marginal Average Total Marginal
Sold(Q) Price(P) Fixed Cost Variable Cost Cost Cost Cost Profit Profit
0 Php24.00 Php8.00 Php0.00 Php8.00 Php0.00 Php0.00 -Php8.00 Php0.00
1 Php22.50 Php8.00 Php4.50 Php12.50 Php4.50 Php12.50 Php10.00 Php18.00
2 Php21.00 Php8.00 Php10.00 Php18.00 Php5.50 Php9.00 Php24.00 Php14.00
3 Php19.50 Php8.00 Php16.50 Php24.50 Php6.50 Php8.17 Php34.00 Php10.00
4 Php18.00 Php8.00 Php24.00 Php32.00 Php7.50 Php8.00 Php40.00 Php6.00
5 Php16.50 Php8.00 Php32.50 Php40.50 Php8.50 Php8.10 Php42.00 Php2.00
6 Php15.00 Php8.00 Php42.00 Php50.00 Php9.50 Php8.33 Php40.00 -Php2.00
7 Php13.50 Php8.00 Php52.50 Php60.50 Php10.50 Php8.64 Php34.00 -Php6.00
8 Php12.00 Php8.00 Php64.00 Php72.00 Php11.50 Php9.00 Php24.00 -Php10.00
9 Php10.50 Php8.00 Php76.50 Php84.50 Php12.50 Php9.39 Php10.00 -Php14.00
10 Php9.00 Php8.00 Php90.00 Php98.00 Php13.50 Php9.80 -Php8.00 -Php18.00

1. At what quantity is the profit maximization? 5 units

C. DEMAND
1. What is demand?
Demand is the total quantity customers are willing and able to purchase under various
market conditions.
Law of demand states that as the price of a good rises(falls) and all other things remain
constant, the quantity demanded of the goods falls(rises).
2. What are the determinants of demand(demand shifters)?
Price of the goods, availability of the goods, expectations of price change, consumer
income, consumer tastes and preferences, advertising expenditures
All of these except for the price are also known as demand shifters. Demand shifters are
explained below:
A. Income
Normal goods are goods that increases(decreases) in demand when income
increases(decreases)
Inferior goods are goods that decreases(increases) in demand when income
increases(decreases)
 B. Price or related goods
Substitute goods are goods that the increase(decrease) in price will lead to an
increase(decrease) in the demand of the other goods.
Compliment goods are goods that the increase(decrease) in price will lead to a
decrease(increase) in the demand of the other goods.
C. Advertising and consumer tastes
Advertising provides information on the existence and quality of the product. This
is known as informative advertising.
Advertising that influence demand by altering taste of consumers is known as
persuasive advertising.
D. Population
Rise in population will increase demand of products.
E. Consumer Expectation
If consumer expect prices to go up next year, the demand this year is higher. This
usually happen on expensive products. This behavior is called stockpiling.
Substituting current purchases for future purchases.
F. Other Factors-example of variables that affects willingness to purchase are
known as potential demand shifters such as birth of a baby(diapers) and
health scares(cigarettes).
3. Differentiate Direct Demand and Derived Demand
Direct Demand is the demand for consumption of products while Derived
Demand(Input Demand) is the demand for inputs used in production.
4. What is Theory of consumer behavior?
Theory of consumer behavior relates to direct demand for personal
consumption products.
5. What is market demand function?
 is the relation between quantity sold and factors influencing its level.
 a function that describes how much of a good will be purchased at alternative
price of the goods and related goods, alternative income levels and other
alternative values of other variables affecting demand.
 Qdx = f(Px ,Py, M, H)
Where: Qdx = Quantity demanded of good X
Px=Price of good X
Py=Price of related good
M=Income
H=value of other variable such as advertising and population
6. What is a linear demand function?
A representation of a demand function in which the demand for a given good is a
linear function of prices, income levels and other variables affecting demand.(a0, ax are
called parameters)
Qdx = a0 + axPx + ayPy + amM +ahH
If ay is positive good X is a substitute good
If ay is negative good X is a complement good
If am is positive good X is normal good
If am is negative good X is an inferior good

7. Differentiate industry demand and firm demand

Industry demand considers variable such as population growth while firm
demand considers variable such as competitor’s prices and advertising expenditures.
 8. Calculate demand

9. What is Demand curve?

Demand curve is the relation between price and the quantity demanded holding
all else constant.
10. What is change in quantity demanded?
Change in quantity demanded is the movement along a demand curve reflecting
a change in price.
11. What is shift in demand curve?
Shift in demand curve is a switch from one demand curve to another another
following a change in nonprice determinant of demand.

D. SUPPLY
1. What is supply?
Supply is defined as the quantity that sellers are willing to sell. Total quantity
offered for sale under various market conditions.
Law of supply states that as price increases the quantity supplied increases but as
price decreases the quantity supplied decreases. Price and quantity supplied are directly
proportional.
2. How output prices affect supply
a. Higher prices increases supply
b. Higher marginal revenue increases supply(applicable also for mix products)

3. Other factors that influence supply

Technology, weather, input prices etc.

4. What is market supply function?

 is the relation between the quantity supplied and all factors influencing its
level.
 a function that describes how much of a good will be produced at alternative
prices of that good, alternative input prices, and alternative values of other
variables affecting supply.
Qsx = f(Px ,Pr, W, H)
Where: Qsx = Quantity supplied of good X
Px=Price of good X
Pr=Price of technologically related good
W=Price of an input
H=value of other variable such as number of firms and taxes

5. What is a supply linear function?

A representation of the supply function in which the supply of a given good is a
linear function of prices and other variable affecting supply.
Qsx = B0 + BxPx + BrPr + BwW +BhH
6. Calculate supply

7. What are the determinants of supply(supply shifters)

a. Input prices
b. Number of firms
c. Technology and government regulations
d. Substitute in production
e. Taxes
8. Industry supply versus Firm supply
Industry supply considers variable such as different production method, labor of
varying skill and compensation levels apply by different firms while firm supply
considers variables applicable to a specific firm.
9. Supply curve
Supply curve is the relation between price and the quantity supplied holding all
else constant.

10. What is change in quantity supplied?

Change in quantity supplied is the movement along a given supply curve
reflecting a change in price.

11. What is shift in supply curve?

Shift in supply curve is the movement from one supply curve to another
following a change in nonprice determinants of supply.
12. What is Market equilibrium?
Market equilibrium is when quantity demanded and quantity supplied are in
perfect balance at a given price, the product market is said to be in equilibrium.
Formula:
Qd = Qs
13. What is surplus?
A surplus is created when producers supply more of a product at a given price
than buyers demand. Surplus describes a condition of excess supply.

14. What is shortage?

A shortage is created when buyers demand more of a product at a given price
than producers are willing to supply. Shortage describe a condition of excess demand.

15. Differentiate price ceiling and price floor

Price ceiling is the maximum legal price that can be charged in a market.
Price floor is the minimum legal price that can be charged in a market.
E. DEMAND ANALYSIS

1. What is Utility theory?

Utility Theory means the ability of goods and services to satisfy consumer wants is the
basis for consumer demand.

Consumer is an individual who purchases goods and services from firms for purpose of
consumption.

Consumer opportunities represents the possible goods and services consumers can
afford to consume.

Consumer preferences determine which of these goods will be consumed.

2. Enumerate the basic assumptions regarding utility as basis for consumer behavior

 more is better
Consumers always prefer more to less of any goods or services. Economist refer
to this as nonsatiation principle.
 preferences are complete
If preferences are complete consumers are able to compare and rank the benefits
tied to consumption.
 Indifference means that two goods provide the same level of satisfaction.
preferences are transitive
If preferences are transitive consumer are able to rank order the desirability of
various goods and services.

Ordinal utility- rank ordering of preferences for example A is better than B.

Cardinal utility- understanding of the intensity of preference for example A=2B

3. What is utility function?

Utility function is a descriptive statement that relates well-being to the consumption of
goods and services.
Utility=f(Goods,services)

Utils are unit of utility well-being.

3. What is marginal utility?

Marginal utility is the added satisfaction derived from a 1 unit increase in consumption.
 5. What is law of diminishing marginal utility?

Law of diminishing marginal utility means that as an individual increases consumption

of a given product within a set period of time, the marginal utility gained from
consumption eventually declines.

6. What is indifference curve?

Indifference curve is a representation of all market baskets that provide a given

consumer the same amount of utility or satisfaction.

7. Differentiate Perfect substitute versus Perfect complements

Perfect substitute are goods and services that satisfy the same need or desire. While,
Perfect complements are goods and services consumed together in the same
combination.

8. What are budget constraints and characteristic of budget constraints?

Budget constraint is a combination of products that can be purchased for a fixed

amount.

Total budget= PyY + PxX

Where: Py= Price of Goods

Y= Quantity of Goods
Px= price of Services
X= Quantity of Services

9. What is the effects of changing income and changing prices?

When income increase the budget line will shift to the right because more goods are
affordable. While decrease in price increases consumption.

10.Explain income and substitution effect

Income effect is the increase in overall consumption made possible by a price cut or
decrease in overall consumption that follows a price increase. While, substitution effect
is the change in relative consumption that occurs as consumers substitute cheaper
products for more expensive products.
11.What is elasticity?
Elasticity is a measure of the responsiveness of one variable to changes in another
variable.
Elasticity is the percentage change in one variable that arises due to a given percentage
change in another variable.
12.What is own price elasticity of demand(point elasticity)?
Own price elasticity of demand is a measure of the responsiveness of the quantity
demanded of a good to a change in the price of that good.
Own price elasticity of demand is the percentage change in quantity demanded divided
by the percentage change in the price of the good.
Own price elasticity is use if change in X(independent variable, Price) is less than 5%.
Own Price Elasticity = % change in Quantity Demanded
% change in Price

13.Differentiate elastic demand, inelastic demand and unitary elastic demand.

Demand is elastic if the absolute value of the own price elasticity is greater than 1.
Demand is inelastic if the absolute value of the own price elasticity is less than 1.
Demand is unitary elastic if the absolute value of the own price elasticity is equal to 1.
14.Computation of own price elasticity.

Price of Quantity of Own Price

Software Sofware Sold Elasticity Total Revenue
Px Qx Px * Qx
A 0 80 - 0 Inelastic
B 5 70 (0.14) 350 Inelastic
C 10 60 (0.33) 600 Inelastic
D 15 50 (0.60) 750 Inelastic
E 20 40 (1.00) 800 Unitary Elasticity
F 25 30 (1.67) 750 elastic
G 30 20 (3.00) 600 elastic
H 35 10 (7.00) 350 elastic
I 40 0 - 0 elastic
15. Total revenue test
If demand is elastic, an increase(decrease) in price will lead to a decrease(increase) in
total revenue. If demand is inelastic, an increase(decrease) in price will lead to an
increase(decrease) in total revenue. Finally, total revenue is maximized at the point where
demand is unitary elastic.
16. What is arc elasticity?
Arc elasticity is the average elasticity over a given range of a function.
Arc elasticity is use if change in X(independent variable, Price) is more than 5%.
ARC PRICE ELASTICITY = change in quantity demanded * Average P
change in price * Average Q

Average P= (P1 + P2)/2

Average Q=(Q1 + Q2)/2

17. Calculate arc elasticity.

         
  Quantity Price  
343,00 160,80
Q1 0 0 P1  
335,00 164,00
Q2 0 0 P2  
   
Arc Elasticity= Change in Quantity *
  (P1+P2)/2  
Change in Price *
  (Q1+Q2)/2  
  = (343,000-335,000) * (160,800+164,000)/2
  (160,800-164,000) * (343,000 + 335,000)/2
1,299,200,0
  = 00  
(1,084,800,0
  00)  
  = -1.20  elastic  
 18.What is cross-price elasticity?
Cross-price elasticity is a measure of the responsiveness of the demand for a good to
changes in the price of a related good.
Cross-price elasticity is the percentage change in the quantity demanded of one good
divided by the percentage change in the price of related good.
If the coefficient is positive the commodities are substitutes.
If the coefficient is negative the commodities are complements.

Point Cross Price Elasticity = % change in the quantity demanded of one good
% change in the price of the related good

Arc Cross Price Elasticity=%change in the quantity demanded of one good *Average P
% change in the price of the related good * Average Q

19. Calculate cross-price elasticity

F. DEMAND ESTIMATION

1. How to determine what the customer wants?

A. Consumer Interview- Questioning costumers to estimate demand relation.

B. Market Experiments- Demand estimation in a controlled environment.

2. What is market demand curve?

Price-quantity demanded relation for all customers.

3. What is scatter diagram?

Plot of XY data.(Y-dependent variable and X-independent variable)

4. What is the difference between simple regression model and multiple regression model.
Simple regression model shows relationship between one dependent variable(Y) and
one independent variable(X).
Multiple regression model shows relationship between one dependent variable(Y) and
two or more independent variable(X).

G. Understand production and competitive markets

1.What is production function?
Production function is the maximum output that can be produced for a given amount of
input.
2.Differentiate discrete production function and continuous production function.
Discrete production function is a production function with distinct input patterns.
Includes variable that are discrete or countable or nothing in between example
number of students.
Continuous production function is a production function where inputs can be varied in
an unbroken marginal fashion. Includes variables that are infinite and something in
between example time and height.
 3.What is returns to scale?
Returns to scale is the relation between output and variation in all inputs taken together.
Formula:
R= %∆ in Output
%∆ in Input

Units of Capital Units of Labor Total Input Total Output Change in Total Input Change in Total Output Return to Scale Interpretation
20 150 170 3000
40 300 340 7500 100% 150% 1.50 Increasing
60 450 510 12000 50% 60% 1.20 Increasing
80 600 680 16000 33% 33% 1.00 Constant
100 750 850 18000 25% 13% 0.50 Decreasing

Increasing return to scale is when the proportional increase in output is larger that an
underlying proportional increase in input. Factors include technical and managerial
indivisibilities, higher degree of specialization, and dimensional relations. % change in output is
greater than % change in input.
Constant return to scale is when a given percentage increase in all input leads leads to an
identical percentage increase in output. Factors include limitation in economies of scale.%
change in output is equal to % change in input.
Decreasing return to scale is when output increases at a rate less than the proportional increase
in input. Factor includes diseconomies of scale. % change in output is less than % change in
input.
4.What is total product and marginal product?
Total product is the whole output from a production system.
Marginal product is the change in output associated with 1 unit change in a single input.
Illustration 1:Calculate total product, marginal product, and average product.
Table 1:Total product, marginal product and average product
Total Product
Input of the Marginal Product Average Product Stage
Quantity(x) input(x) of the input(x) of the input(x)
1 15 15 15
2 31 16 16 Stage 1
3 48 17 16
4 59 11 15
5 68 9 14
Stage 2
6 72 4 12
7 73 1 10
8 72 -1 9
Stage 3
9 70 -2 8
10 69 -1 7
11 64 -5 6 Stage 4
12 60 -4 5

5. What is law of diminishing returns?

Law of diminishing returns states that as the quantity of a variable input increases, the
resulting rate of output increase eventually diminishes.
Law of diminishing returns states that the marginal product of a variable factor
eventually declines as more of the variable factor is combined with other fixed resources.
The law of diminishing returns is sometimes called the law of marginal diminishing
marginal returns to emphasize the fact that it deals with the diminishing marginal
product of a variable input factor.
The production function shows that stretching the use of variable resources against the
limits of fixed resources decreases additional product.
 Illustration 2:
Table 2:Production Function for Tax-Return Processing
Total Product
of CPA's(Tax
Units(Hour) of Return
Labor Input Processed per Marginal Product Average Product
Employed(CPA's) Hour) of CPA's of CPA's
1 0.20 0.20 0.20
2 1.00 0.80 0.50
3 2.40 1.40 0.80
4 2.80 0.40 0.70
5 3.00 0.20 0.60
6 2.70 (0.30) 0.45

The marginal product of the fourth CPA is less than the marginal product of the third
CPA. In this case the diminishing return is encountered. Causes may include
problems in coordinating work among greater number of employees or limitation in
other important inputs. No firm would pay additional employee when employing
that person reduces output.
6.What is isoquant?
Isoquant is derived from “iso” meaning equal and “quant” from quantity.
Isoquant(product indifference curve) denotes a curve that represents the different
combinations of inputs(capital and labor) that can be efficiently used to produce a given
level of output(maximum output).
There is an inverse relationship from one resource(capital) to another(labor) which means
by using less of one is regained by using more of the other.
Production capacity is considered constant regardless of the resource combination.
Resource input foregone is not necessarily equal to resource input gained to maintain
plant capacity and their rates of substitution are not even constant along the curve.
7.What is marginal rate of substitution?
Marginal rate of substitution(MRS) is defined as how much of one resource is given up
in order to use an additional unit of the other given a fixed capacity.
 Formula:
MRS= ∆Y axis = change in Y axis
∆X axis change in X axis

Illustration 3:

Table 3: Isoquant
Labor Input(X- Capital MRS(∆Capital/
axis) Input(Y-Axis) ∆Labor)
1 30 -
2 20 10.00
3 17 3.00
4 15 2.00
5 14 1.00

8.What is isocost curve?

Isocost(Budget Line) is a combination of inputs whose cost equals constant expenditure.
Isocost curve defines the cost and budgetary limits of production.
Illustration 4:
Table 4: Isocost and its heirarchy
Budget= P10,000 Budget = P20,000
Capital Labor Capital Labor
5 0 10 0
4 4 8 8
3 8 6 16
2 12 4 24
1 16 2 32
0 20 0 40
Price of capital= P2,000
Price of labor = P500
MRS = 0.25

9.What is productivity growth and causes of productivity growth?

Productivity growth is the rate of increase in output per unit of input.
 Cause of productivity growth:
1. Efficiency gains-improvements in how labor and capital are used.
1.1 Change the nature of resource through innovation
1.2 Advancement in hardware technology for the electronic information industry.
1.3 Change external condition of resources
1.4 More balanced resource combination
1.5 Using resource-saving technology
2. Capital deepening- growth in the amount of capital that workers have available for use.

H. Understanding Cost Concepts

1. Differentiate historical cost, replacement cost and current cost.

Historical cost is the original cost of an asset. Historical cost valuation shows the
cost of an asset as the original price paid(actual cash outlay) for the asset acquired
in the past. Historical valuation is the basis for financial accounts. A replacement cost
is the price that would have to be paid currently to replace the same asset. During
periods of substantial change in the price level, historical valuation gives a poor
projection of the future cost intended for managerial decision. Historical cost is that
type of cost which is based on the purchase price of machinery initially. This
cost is based on the point of view of an accountant because an accountant will show
machine in his balance sheet at the original cost rather than the present cost
prevailing in the market or market cost of the machine.

A replacement cost is a relevant cost concept when financial statements have to

be adjusted for inflation. It is the cost of duplicating productive capability using
current technology. When an old machine is replaced with a new machine the cost
incurred in such replacement is called replacement cost. It is also called substitution
cost. It is important for such business firm where projects are replaced and production
process is changed. Replacement cost plays an important role in business decision-
making because it affects the total cost of a business firm.

Current cost is the amount that must be paid under prevailing market conditions.
Current cost is influenced by the number of buyers, sellers, technology and inflation.
For asset purchased recently the historical cost and the current cost are typically the
same. For assets, purchased several years ago historical cost and current cost can be
quite different.
 2. What is opportunity cost?

According to an economist point of view there is also a concept of cost known as

opportunity cost. Modern economists have propounded this concept. It is also called
alternative cost, transfer income and transfer cost. It is economic cost of
production of a commodity. Economics deals with unlimited wants and limited or
scarce means which have alternative uses.

Hence, every economic decision involves a choice between alternative uses. According to
opportunity cost production of each commodity involves the cost in the form of sacrifice
in the sense that a commodity is not produced because of alternative uses and scarce
means in the economy. For example, X commodity is produced and

production of commodity Y forgone.Hence, the cost of production of X is the commodity

Y foregone. The alternative forgone is the opportunity cost of alternative chosen. The
opportunity cost of any commodity is the second best alternate by which another
production of a commodity from the same means was possible.

On the other hand opportunity cost implies the earnings foregone on the next best
alternative, has the present option is undertaken. This cost is often measured by assessing
the alternative, which has to be scarified if the particular line is followed. The opportunity
cost concept is made use for long-run decisions. This concept is very important in capital
expenditure budgeting. This concept is very important in capital expenditure budgeting.
The concept is also useful for taking short-run decisions. Opportunity cost is the cost
concept to use when the supply of inputs is strictly limited and when there is an
alternative. If there is no alternative, opportunity cost is zero. The opportunity cost of any
action is therefore measured by the value of the most favorable alternative course, which
had to be foregoing if that action is taken.

3. Differentiate incremental cost and sunk cost

When a business firm changes its business activities or nature of its business, then the
incremental costs are incurred by the firms. It is the cost due to change in the total
cost due to change in the level of business activity or by a given managerial decision. For
example, a business firm purchases new machinery in place of old machinery or a new
product is included in the process or production and all such changes increases the total
cost of production of that firm then it is called incremental costs. The difference between
the changed total cost and initial total cost (before such change) is incremental cost.

It is calculated on the basis of the following formula:

Incremental Cost = Changed Total Cost – Initial Total Cost

Sunk costs are those costs which are not affected by the changes in the level of business
activity or nature of business of a business firm. These costs remain unchanged.
Depreciation is an example of such costs. Such costs are also known as bad debt costs.
 When investment is made in a sick unit it is a bad debt because the investment
made by the business manager may be recovered or may not be recovered. When
such business firm is auctioned and whatever receivables they are included in the sunk
cost.

Both incremental and sunk costs are important when the various alternatives are
evaluated by the business manager while taking the business decisions. The incremental
costs differ from one alternate to another while sunk costs do not change.

Incremental cost also known as different cost is the additional cost due to a change in the
level or nature of business activity. The change may be caused by adding a new
product, adding new machinery, replacing a machine by a better one etc. Sunk
costs are those which are not altered by any change – They are the costs incurred in the
past. This cost is the result of past decision, and cannot be changed by future
decisions. Investments in fixed assets are examples of sunk costs

4. Differentiate fixed cost and variable cost

Fixed costs are those costs which are fixed whether production is being carried on or
there is no production at all. These costs are short run costs wherein they remain
fixed from zero production to the maximum possible production of a business firm.
These costs are borne by the firm. These costs are called supplementary costs, general costs,
indirect costs and overhead costs. Rent of building, land tax, insurance premium,
depreciation, salaries to managers, interest on permanent or fixed capital, etc., are examples of
such costs. Fixed cost is that cost which remains constant for a certain level to output. It is not
affected by the changes in the volume of production. But fixed cost per unit decrease,
when the production is increased. Fixed cost includes salaries, rent, administrative
expenses, depreciation’s etc

Variable costs are those costs which are directly related to production of a firm. They
vary with the production. When production is not carried on such costs will not arise.
Cost of raw materials, direct wages, expenses on fuel, etc., are the examples of such
costs. These costs depend upon the volume of output. Variable is that which varies directly with
the variation is output. An increase in total output results in an increase in total variable
costs and decrease in total output results in a proportionate decline in the total variables
costs. The variable cost per unit will be constant. Ex: Raw materials, labor, direct
expenses, etc.

5. Differentiate Long-run cost and short-run cost

Short run costs are those costs which are concerned with the short run production of a
firm.They are of two types, namely, fixed costs and variable costs. Short-run is a period
during which the physical capacity of the firm remains fixed. Any increase in output
during this period is possible only by using the existing physical capacity more
extensively. So short run cost is that which varies with output when the plant and capital
equipment in constant.
 Long run costs are those costs which are concerned with the long run process of
production. In the long run all the factors of production are variable and even the scale of
production can be changed. All the costs during long run are variable costs. Long
run costs are those, which vary with output when all inputs are variable including
plant and capital equipment. Long-run cost analysis helps to take investment
decisions.

6. Differentiate Traceable and Common costs

Traceable costs otherwise called direct cost, is one, which can be identified with
a products process or product. Raw material, labor involved in production is
examples of traceable cost. Common costs are the ones that common are
attributed to a particular process or product. They are incurred collectively for different
processes or different types of products. It cannot be directly identified with any
particular process or type of product.

7. Differentiate Avoidable and Unavoidable costs

Avoidable costs are the costs, which can be reduced if the business activities of a
concern are curtailed. For example, if some workers can be retrenched with a drop in a
product – line, or volume or production the wages of the retrenched workers are
escapable costs. The unavoidable costs are otherwise called sunk costs. There will not be
any reduction in this cost even if reduction in business activity is made. For
example cost of the ideal machine capacity is unavoidable cost.

8. Differentiate Controllable and Uncontrollable costs

Controllable costs are ones, which can be regulated by the executive who is in change of
it. The concept of controllability of cost varies with levels of management. Direct
expenses like material, labour etc. are controllable costs. Some costs are not directly
identifiable with a process of product. They are appointed to various processes or
products in some proportion. This cost varies with the variation in the basis of allocation
and is independent of the actions of the executive of that department. These apportioned
costs are called uncontrollable costs.

9. Differentiate Accounting and Economics costs

Accounting costs are the costs recorded for the purpose of preparing the balance sheet
and profit and ton statements to meet the legal, financial and tax purpose of the
company. The accounting concept is a historical concept and records what has happened in
the post. Economics concept considers future costs and future revenues, which help future
planning, and choice, while the accountant describes what has happened, the economics
aims at projecting what will happen.
 10. Differentiate Explicit and Implicit costs

Explicit costs are those expenses that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of
wages and salaries, payment for raw-materials, interest on borrowed capital funds, rent
on hired land, Taxes paid etc.These costs consist of all the payments made on the basis of
contract to various factors of production employed by a firm, namely, factor prices, prices
of raw materials, rent, wages, interest, salaries, depreciation of plant and machinery and
selling cost incurred during a given period of time. The record of such costs is maintained
by the accountant.

Implicit costs are the costs of the factor units that are owned by the employer himself.
These costs are not actually incurred but would have been incurred in the absence
of employment of self – owned factors. The two normal implicit costs are depreciation,
interest on capital etc. A decision maker must consider implicit costs too to find out
appropriate profitability of alternatives. These costs are invisible costs of production. The
payment made to the owned factors of production is included in these costs. Interest on
owned capital, wages to own labour, salary to owned managers, owned building,
furniture and other infrastructures of the owner of the firm are part and parcel of implicit
costs. The calculation of implicit cost is not an easy task.

11.What is economies of scale?

Economies of scale exist when the long-run average cost decline as output expands.
Labor specialization and technical factors often give rise to economies of scale.

12. What is cost elasticity?

Cost elasticity is the percentage change in total cost associated with a 1% change in
output.

Cost elasticity(also called cost-output elasticity) measures the responsiveness of total

cost to changes in output. It is calculated by dividing the percentage change in cost
with percentage change in output. A cost elasticity value of less than 1 means that
economies of scale exists. Economies of scale exist when increase in output is
expected to result in a decrease in unit cost while keeping the input costs constant. Such a
reduction in average cost may occur, for example, when workers are able to specialize
which increases their productivity, when the firm is able to negotiate more effectively
with suppliers and receive volume discounts, etc.
 13. Compute for cost elasticity

Cost elasticity is related to economies of scale as follows:

If Then Which Implies

Percentage change in TC<Percentage Economies of scale(decreasing
change in Q Cost Elasticity<1 AC)
Percentage change in TC=Percentage No economies of scale(Constant
change in Q Cost Elasticity=1 AC)
Percentage change in TC>Percentage Diseconomies of
change in Q Cost Elasticity>1 scale(increasing AC)

14. What is cost-volume-profit analysis?

Cost-Volume profit analysis is an analytical technique used to study relations among
costs, revenues and profit.
Cost-volume-profit analysis, sometimes called breakeven analysis, is an important
analytical technique used to study relations among costs, revenues, and profits.
15. What is break-even quantity?

A breakeven quantity is a zero profit activity level. At breakeven quantity levels, total
revenue (P*Q) exactly equals total costs (TFC + AVC * Q):
TotalRevenue=TotalCost
P*Q=TFC+AVC*Q
(P – AVC)Q = TFC
It follows that breakeven quantity levels occur where

QBE = TFC/ P – AVC

Thus, breakeven quantity levels are found by dividing the per-unit profit contribution into
total fixed costs.
 In the example illustrated in Figure, P  = $3, AVC = $1.80, and TFC = $60,000.
Profit contribution is $1.20 (= $3.00 – $1.80), and the breakeven quantity is

Q=$60,000
$1.20
= 50,000 units

H. Competitive Market
1. What is market and market structure?

Market is composed of firms and individuals willing and able to buy or sell a given
product. This includes firm and individuals currently engaged in buying and selling
particular product as well as potential entrants.
Market Structure describes the competitive environment in the market for any good or
service.

2. What are the factors that shape the competitive markets?

2.1 Product Differentiation- Real or perceived differences in the quality of goods

and services. Sources of product differentiation include physical differences such
as those due to superior research and development, plus any perceived differences
due to effect advertising and promotion.
2.2 Production Methods
2.3 Entry and Exit Conditions
a. Barrier to Entry-Any factor or industry characteristic that creates an advantage
for incumbents over new arrivals.
b. Barrier to Mobility-Any factor or industry characteristic that creates an
advantage for large leading firms over smaller nonleading rivals.
c. Barrier to Exit- Any restriction on the ability of incumbents to redeploy assets
from one industry or line of business to another.

3. What are the characteristic of a perfect competition?

3.1 Large number of buyers and sellers
3.2 Product homogeneity
3.3 Free entry and exit
 3.4. Perfect dissemination of information
3.5 Opportunity for normal profits in the long-run equilibrium

4. What is profit maximization in competitive markets?

Total profit is maximized when the difference between marginal revenue and
marginal cost called marginal profit equals zero.

I. Understand performance and strategy in competitive markets

1.Define welfare economics, social welfare, consumer surplus, producer surplus and
deadweight loss problem

Welfare economics is the study of how the allocation of economic resources affects the
material well-being of consumers and producers.
Social welfare is the material well-being of the society.
Consumer surplus is the net benefit derived by consumers from consumption.
Producer Surplus is the net benefit derived by producers from production.
Deadweight loss problem is the decline in social welfare due to competitive market
distortion.

2.Calculate equilibrium price-output, consumer surplus, producer surplus and social

welfare.

3.What are the characteristic of a purely competitive market?

 There is a large number of sellers and buyers of commodity, each too small to affect
the price of the commodity
 The outputs of all firms are homogeneous, the product of any seller is considered
exactly alike in all respects to the product of any other seller
 There is a perfect mobility of resources, there is freedom of entry into and exit from
the industry

3.Differentiate pure and perfect competition

A market characterized as pure competition includes all the characteristics above while
a perfectly competitive market includes also all the characteristic mentioned
plus an additional characteristic which is consumers, resource owners and firms in
the market have perfect knowledge of present and future prices and costs.

4.What is perfect knowledge?

Perfect knowledge means that a person knows the price of a commodity being charged
in the markets.
 5.Explain market failure

Market failure maybe a result of one of the following:

 When a group of sellers can exert undue influence in increasing the price and
restricting supply.
 When the prices paid by the consumers exceeds the marginal cost of production.
 When sellers earn above normal rate of return which results to above normal profits
reflecting an exercise of market power.
 When there is limited number of sellers such as in utility markets(water, electricity)

6.Explain roles of government

The government affects market economy by:

 What and how firms produce
 Influences conditions of entry and exit
 Dictates marketing practices
 Prescribes hiring and personnel policies

7.What is subsidy and tax policy

Subsidy is a government support strategy.

Tax policy are base on laws implemented by regulatory agencies.

8.What is price controls(Price ceilings and price floors)

Price floor is the minimum price while price ceiling is the maximum price. Public policy
sets a price floor in an effort to boost producer income. Price floor can result in
surplus production and a significant loss in social welfare. A price ceiling is a
costly and seldom
used mechanism for restraining excess demand. Price ceiling can result in excess
demand, shortage, and a significant loss in social welfare.

9.Explain business profit rates

A. Return on Stockholder’s Equity can also be described as the product of three

common accounting ratios. ROE equals the firms profit margin multiplied by the total
asset turnover multiplied by leverage ratio.

Formula:
 ROE= Net Income/Equity

*Equity=Total Assets minus Total Liabilities

B. Profit margin is the amount of profit earned expressed as a percentage of sales.

Formula:
Profit Margin=Net Income/Sales

C. Total Asset Turn-over measures how the company’s asset is use to generate revenue.

Formula:
Total Asset Turn-over=Sales Revenue/Book Value of the total assets

D. Leverage reflects the extent to which debt is used in addition to common stock
Particulars Amount financing.
Shareholder Equity  
Formula:
Equity Shares, 2346 share outstanding, Leverage=Total
Par value 0.05 118 Assets/Stockholder’s Equity
Paid In Capital 5,858

Retained Earning 13,826 Problem Illustration:

Total Shareholder Equity 19,802

Total Assets 30,011

Current Liability 8,035

Total Sales 53,553

Gross Profit 16,147

Net Operating Profit 3,029

Net Profit 3,044

*all in millions

Solution:

ROE= Net Income/Equity=3,044/19,802=0.15

Profit Margin=Net Income/Sales=3,044/53,553=0.06

Total Asset Turn-over=Sales Revenue/Book Value of the total

assets=53,553/30,011=1.78

Leverage=Total Assets/Stockholder’s Equity=30,011/19,802=1.52

J. Imperfect Competition: Understand Monopoly and Monopsony

1.What is monopoly?

Monopoly exists when a firm is the sole producer of a distinctive good or service that has
no close substitutes. In other words, under monopoly the firm is the industry. In the
absence of close substitutes, monopoly firms has significant discretion when it comes to
setting prices. Monopoly firms are price makers as opposed to firms in competitive
markets who are price takers. Monopoly firms also enjoy the ability to earn above-normal
profits in long-run equilibrium.

2.What are the common characteristic monopoly markets?

 A single-seller. A single firm produces all industry output. The monopoly is the
industry
 Unique product. Monopoly output is perceived by customers to be distinctive and
preferable to its imperfect substitutes.
 Blockaded entry and/or exit. Firms are heavily restricted from entering or leaving
the industry.
 Imperfect dissemination of information. Cost, price, and product quality
information is withheld from uninformed buyers.
 Opportunity for economic profits in long-run equilibrium. Distinctive products
 allow P>MC

3.Give examples of monopoly in the Philippines

Cite examples and explain(Electricity, Telecommunications, Transport). Case study:

Villar bills goes after monopolies

4.Explain profit maximization under monopoly

Monopoly firms maximizes profit by setting marginal revenue equal to marginal cost.

` 5.Define price maker

Buyers and sellers whose large transactions affect market price.

6.What are the social costs of monopoly?

 Monopoly firms have incentives to restrict output so as to create scarcity and earn
economic profits. This is called monopoly underproduction. Monopoly
underproduction results when a monopoly curtails output to a level at which
marginal value of resources employed as measured by marginal cost of
 production is less than the marginal social benefit derived. Marginal social
benefit is the price that customers are willing to pay for additional output.
Under monopoly marginal cost is less than the price charged at the profit-
maximizing level.
 Monopoly can also result in social costs if the monopolist fail to employ cost-
effective production methods

7.Regulation of Monopoly-Philippines

Public welfare dictates that government should take more active role in the regulations of
monopolies. Philippine Competition Commission (PCC) has been working with
the National Economic and Development Authority (Neda) to formulate the National
Competition Policy (NCP). The Governance Commission for GOCCs, the
Department of Justice-Office for Competition, and the Department of Trade and
Industry, as well as private- sector representatives, have helped to come up with a draft
NCP that is hoped to truly reflect what lawmakers envisioned when they enacted the
Philippine Competition Act (PCA). Guided by the Competition Chapter of the
Philippine Development Plan (PDP) 2017-2022, the NCP, proposed to be issued
as an executive order, will serve as a framework that would steer state policies and
administrative regulations toward the promotion of robust and fair market
competition. It rests on three fundamental pillars: (1) the effective implementation of the
PCA, (2) the enactment of pro-competitive government regulations and (3) the internalization
of the principle of competitive neutrality.
National Competition Policy (NCP), an executive order that lays out a comprehensive
framework that steers regulations and administrative procedures to promote free and fair
market competition.

8.Differentiate Monopsony and Oligopsony

Monopsony is a market structure in which there is a single buyer of a desired product or

output while oligopsony exists when there are only handful of buyers present in a
market.

K. Understand Monopolistic competition and oligopoly

1.Differentiate monopolistic competition and oligopoly
Monopolistic competition is a market structure characterized by a large number of sellers
of differentiated products while oligopoly is a market structure characterized by
few sellers and inter-dependent price-output decisions.
2.What are the characteristics of monopolistic competition?
 Large number of buyers and sellers. Each firm produces a small portion of industry
output, and each customer buys only a small part of the total.
 Product heterogeneity. The output of each firm is perceived to be essentially
different from, though comparable with the output of other firms in the industry
 Free entry and exit. Firms are not restricted from entering or leaving the industry.
 Perfect dissemination of information. Cost, price and product quality information is
known by all buyers and all sellers.
 Opportunity for normal profits in long-run equilibrium. Distinctive products allow
P>MC but vigorous price and product-quality price competition keeps P=AC.
3.What are the barriers to entry into a monopolistic competition?
 Question of size or economies of scale
 Discovery, production, and control of the sources of raw materials
 Patent ownership and research
 Market franchise was awarded by the government
 4.What are the characteristics of oligopoly market?
 Few sellers. A handful of firms produce the bulk industry output. Competing firms
typically recognize their interdependence in price-output decisions.
 Homogenous or unique products. Oligopoly output can be identical or distinctive
 Blockaded entry and or exit. Firms are heavily restricted from entering or leaving
the industry.
 Imperfect dissemination of information. Cost, price and product quality information
is withheld from uninformed buyers.
 Opportunity for economic profits in –long run equilibrium. Competitive advantage
keeps P>MC and P=AR>AC for efficient firms.
5.What is duopoly?
Duopoly is an oligopoly composed of only two firms.
6.Differentiate perfect collusion from imperfect collusion.
Perfect collusion(cartel) is a formal group of competitors operating under a formal overt
agreement. An example of a cartel is the OPEC(Organization of Petroleum
Exporting Countries) which effectiveness leads to an substantial increase in price of
oil benefitting the OPEC countries. An imperfect collusion is an informal covert
agreement of a group of competitors under which the firms of an industry seek to
establish prices and output. Usually, gentlemen’s agreement of various sorts affecting
pricing, ouput, distribution, market sharing and other activities within the industry can
be worked out.
7.What are the advantages of collusion?
 They can increase their profits if they can decrease the amount of competition
among themselves and act monopolistically
 Collusion can decrease oligopolistic uncertainty. If the firm act in concern ,they can
reduce the likelihood of any one firm’s taking actions detrimental to the interest of
the others.
  Collusion among the firms already in an industry will facilitate blocking new
comers from that industry. However once the collusive arrangement is in existence,
any single firm has a profit incentive to break-away from the group and act
independently, thus destroying the collusive arrangement.

8.What are the characteristics of cartel?

 All producers or sellers in the industry are included in the agreement;
 The agreement is definite and enforceable to all parties involved;
 It covers both price to be charged and the quantity of output to be produced by each
agreeing seller and the output allocation being calculated as to minimize the
aggregate cost of producing the total output of the industry.
 It also includes a formula for distributing the profits of the combined operations
among the agreeing parties and;
 All parties adhere rigorously to the terms of agreement
9.Imperfect collusion results from failure to meet the characteristic of perfect collusion in
the following ways:
 Incompletely observed collusion. There is a collusion agreement among existing
sellers, either formal or tacit, aired at fixing prices or outputs but is not rigorously
observed by some or all of the sellers.
 Collusion with indefinite terms of agreement among sellers affecting prices or
outputs. The terms are either ambiguous or ambiguously understood by some or all
of the sellers.
 Collusion with incomplete participation of the sellers in the industry. There is a
formal or tacit agreement among sellers affecting prices and outputs, but not all
members of the industry are parties to the agreement or even nominal adherents to it
and;
 Interdependent action without agreement. There is no formal agreement and not
really a sufficiently sustained uniformity of action over time to permit influence of a
tacit agreement.
10.Differentiate homogeneous products from heterogeneous products
Homogeneous products are very similar in physical composition as well as quality and
the only real difference between various manufacturer’s product is price examples
are gasoline and cement while heterogeneous products are products that cannot be
easily substituted or replaced by others because of the distinct features that make them
unique in certain brands and supplier.Heterogeneous products are designed to attract
different segments of the population one example is the car industry.

11.Classification of oligopoly markets

 Pure or perfect oligopoly- This model is found in some capital goods industries,
such as cement and the oil industries. Mutual interdependence is greater when
products are identical than when they are differentiated. Any price or output change
by one firm is certain to produce substantial effects upon the sales of competitors
that would force them to alter their policies.
 Differentiated or imperfect oligopoly- This model exist when products are not
homogeneous. This model is found in most manufactured consumer goods such as
car industry. In this market, price change will have a less direct effect upon
competitors because of the partial isolation of the market for each firm.The stronger
the differentiation the weaker will be the feeling for mutual interdependence.
12.Various Oligopoly Output-Setting Models
1. Cournot Model- The earliest model of oligopoly that was developed in 1838 by
Augustin Cournot, a French economist. Theory that firms in oligopoly markets
make simultaneous and independent output decisions. In this Theory Firm A and
Firm B have equal output.
What are the characteristic of Cournot Oligopoly
A. There are few firms in the market serving many consumers.
B. The firms produce either differentiated or homogeneous products.
C. Each firm believes rivals will hold their output constant if it changes its
output.
D. Barriers to entry exist.
2. Stackelberg Model- Developed by German economist Heirich von Stackelberg
in 1934. Theory of sequential output decisions in oligopoly markerts. Assume that
the leading firm would take into account the expected output reaction of its
following-firm rival in making its own output decisions. Example if the leading
Firm A enjoys a significant first mover advantage while Firm B accepts the output
decision of Firm A as given and does not initiate price war.
 What are the characteristic of Stackelberg Oligopoly
A. There are few firms serving many customers.
B. The firms produce either differentiated or homogeneous products.
C. A single firm(the leader) chooses an output before all other firms choose their
outputs.
D. All other firms(followers) take as given the output of the leader and choose
outputs that maximize profits given the leader’s output.
E. Barrier to entry exist.
13.Various Oligopoly Prices-Setting Models
1. Bertrand Model- Developed by Joseph Louis Francois Bertrand. This model
contended that oligopoly firms set prices, rather than quantities as maintained in the
cournot model. This model focuses upon price reactions, rather than the output
reactions, of oligopoly firms. Bertrand equilibrium is reached when no firm can achieve
higher profits by charging a different price. According to Betrand, when products and
production costs are identical all customer will purchase from the firm selling at the
lowest possible price.
What are the characteristic of Bertrand Oligopoly
A. There are few firms in the market serving many consumers.
B. The firms produce identical products at a constant marginal cost.
C. Firms engage in price competition and react optimally to prices charged by
competitors.
D. Consumers have perfect information and there are no transaction costs.
E. Barriers to entry exist.
2. Sweezy Model- Developed in 1939 by a Harvard economist named Paul Sweezy.
This theory of oligopoly explains “sticky prices” an often noted characteristic of
oligopoly markets. The Sweezy model hypothesizes that when making price decisions,
oligopoly firms have a tendency to follow rival price decreases to maintain market
shares but ignore rival price increases.
What are the characteristic of Sweezy Oligopoly
A. There are few firms in the market serving many consumers.
B. The firms produce differentiated products.
C. Each firm believes rivals will cut their prices in response to a price reduction but
will not raise their prices in response to a price increase.
 D. Barriers to entry exist.

14.Differentiate price signaling and price leadership

Price signaling is an important collusion by announcing price strategy in the hope that
competitors will follow suit. While Price leadership is a situation in which one
firm establishes itself as the industry trendsetter and all other firms in the industry
accept its pricing policy.

L.Markup pricing and profit maximization

1. Markup on Cost- The difference between price and cost, measured relative to cost and
expressed as a percentage.

Formula:
Markup on cost = (P-MC)/MC

Where: P is Price
MC is marginal cost

2. Optimal Markup on cost- Profit maximizing markup on cost.

Formula:
Optimal Markup on cost = -1/(Price Elasticity + 1)

3. Markup on Price- The difference between price and cost measured relative to price and
expressed as a percentage.
Formula:
Markup on price = (P-MC)/P

4. Optimal Markup on Price- Profit maximizing markup on price

Formula:
Optimal Markup on price = (-1/Price Elasticity)
 Sample Illustrations

1. Calculate for Mark upon cost and Mark upon price

Product Price($) Marginal Cost($) Mark upon cost(%) Mark upon Price(%)
A 2.00 0.75 167% 63%
B 4.00 2.00 100% 50%
C 6.00 3.00 100% 50%
D 8.00 4.50 78% 44%
E 10.00 5.50 82% 45%
F 12.00 6.50 85% 46%
G 14.00 7.50 87% 46%
H 16.00 9.00 78% 44%
I 18.00 10.00 80% 44%
J 20.00 15.00 33% 25%
K 22.00 18.00 22% 18%

2. Calculate for Optimal Mark upon cost and Optimal Mark upon price

Product Price Elasticity Optimal Mark upon cost(%) Optimal Mark upon Price(%)
A -1.50 200% 67%
B -2.00 100% 50%
C -2.50 67% 40%
D -4.00 33% 25%
E -5.00 25% 20%
F -10.00 11% 10%
G -15.00 7% 7%
H -20.00 5% 5%
I -25.00 4% 4%
J -50.00 2% 2%
K -60.00 2% 2%

Prepared by:
Sherryl Lutero-Cao,CPA, CMA, PhD
Suggested Readings:
Managerial Economics By: Mark Hirchey(12th Edition)
Managerial Economics and Business Strategy By: Michael R. Baye and Jeffrey T.
Prince(Ninth Edition)